Cheating the customers

November 08, 2003

There are 95 million mutual fund shareholders in this country. Half of all households have money in these funds. It's just beginning to dawn on many Americans that they've been had by the industry that was supposed to be the rock-solid refuge for their investment and retirement assets.

Their money wasn't stolen. It's still there in the nation's thousands of mutual funds. But many of the fund companies apparently cut deals with big customers that gave them special treatment--at the expense of everyone else. Through illegal late trading and legal market-timing schemes, some of those funds have been knowingly defrauding all their other customers.

The bottom line for tens of millions of average investors is this: They either paid more in fees or received less in overall returns over time because of these abusive practices.

This growing mutual fund scandal is no Enron. There are no complicated off-balance sheet entities hiding debt in a corporate game of three-card monte. No, this is pretty much a straightforward game of rewarding the big-money players at the expense of tens of millions of investors.

Those investors weren't expecting annual double-digit returns anymore; they knew those popped with the market bubble of the late 1990s. They just wanted their money kept relatively safe and they wanted a fair and honest shake from the companies that held their assets. They haven't been getting it and that's an outrage.

"The mutual fund industry is now the world's largest skimming operation," charged Sen. Peter Fitzgerald (R-Ill.) at a Senate hearing Monday into abusive trading practices. Fitzgerald called it a "$7 trillion trough from which fund managers, brokers and other insiders are steadily siphoning off an excessive slice of the nation's household, college and retirement savings."

When New York State Atty. Gen. Eliot Spitzer in September uncovered trading abuses at four major mutual fund companies, he called it just the tip of the iceberg, alleging he had "evidence of widespread illegal trading schemes" that may have cost shareholders billions of dollars a year. Spitzer was right on the money. There aren't just a couple of bad apples in the mutual fund basket. The basket overflows with abuses.

In the wake of Spitzer's initial probe, the Securities and Exchange Commission surveyed the nation's 88 largest mutual fund companies and 34 largest securities firms to determine how widespread these practices are.

The SEC's findings are mind-boggling: Half of the fund companies admitted to helping select customers engage in market timing and a fourth of the brokerage firms assisted select customers in circumventing fund company rules against late trading. Three of 10 fund companies admitted they have disclosed details about their portfolio holdings to select customers and 8 in 10 let intermediaries send in late orders.

Late trading allows investors to benefit from news announced after the market closes. It is flat-out illegal. Market timing allows customers to profit from the fact that mutual fund prices are set just once in a 24-hour day but stock prices change throughout that period. It isn't illegal but many mutual fund companies have insisted they prohibit or discourage it because the rapid, short-term trading it entails raises costs, can dilute the ownership stake of other shareholders and cuts overall returns.

If a fund company says it doesn't allow this practice and yet--wink, wink--does if the customer is rich enough or keeps enough money in the fund, that's an outrageous lie.

John Bogle, founder of The Vanguard Group and a longtime industry critic, says that this scandal could turn out to be a "blessing in disguise" that will shine a spotlight on shadowy practices and force more transparency and disclosure. All of that will benefit average investors, as will more specific information on the $123 billion in fees the fund companies collect each year from investors.

The SEC, the National Association of Securities Dealers, New York's Spitzer and other state securities offices have opened dozens of investigations into illegal or deceptive fund practices that are likely to lead to criminal and civil charges. Two company CEOs already have quit under pressure. They won't be the last. Spitzer is vowing to make the fund companies disgorge all the management fees they received during the period in which they allowed improper trading, which would total billions of dollars.

There are any number of reforms being bandied about. Some sound particularly worthy, such as ending the clubby nature of mutual fund company boards. Clubbiness begets the same insularity at mutual fund companies as at other corporations. The boards of these companies should be independent. That's because the board members' main mission is to look out for the interests of all investors, large and small. Everyone should be treated the same. The penalties for failing in this mission must be swift and severe.

The bottom line for this industry is restoring--quickly-- the investor trust some of its members so arrogantly and cavalierly tossed aside. That means swiftly enacting reforms. The bottom line for each of the nation's 95 million mutual fund shareholders is this simple question: Does the fund that holds your money treat you fairly and honestly? If you think it doesn't, remember, it's your money--and money walks.